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Introduction

Stable value funds are typically considered to be a “safe” investment option in many defined contribution plans. They are designed to preserve principal
and generate steady rates of return, while allowing participants to make withdrawals at contract value (principal plus accrued income), regardless
of market conditions.

Over the long run, stable value funds have delivered returns that are similar to the returns of intermediate-term bonds; yet the volatility of those
returns has been equal to or less than that of money market funds. This favorable risk/return profile is one of the main reasons that stable value
is such a popular choice among plan participants.

Stable value funds typically have durations of about three years, which helps explain their bond-like returns. But how do they maintain such low volatility?
The answer lies with the mechanics of contract value accounting provided through contracts issued by high quality financial institutions. Stable
value funds are able to report smooth returns because investment contracts are benefit responsive and insulate participants from movements in bond
prices and changes in market interest rates. This smoothing effect is achieved through the crediting rate. Financial institutions that issue investment
contracts calculate the initial crediting rate and then reset it periodically, typically on a quarterly basis.

What is a crediting rate?

A crediting rate is the interest rate earned on the contract value (principal plus accrued income) expressed as an effective annual yield. The crediting
rate also acts as a stabilizing mechanism by amortizing investment gains and losses so that participants are protected from short-term changes
in market value. Principal preservation is furnished by a contractual minimum crediting rate of 0% and contractual provisions that require the
contract issuer to make payments at contract value in the event that the supporting fixed income investments are depleted.

How is a crediting rate calculated?

It is the underlying bond portfolio’s performance that ultimately determines the crediting rate of a participating separate account GIC and a security
backed investment contract. Thus, the crediting rate formula is a function of the contract value of the investment contract, the market value of the
underlying bond portfolio, and the yield and duration of the underlying bond portfolio. The crediting rate is designed to converge the difference in
the investment contract’s value and the market value of its underlying collateral by amortizing those differences over time. This convergence is represented
as a market value to contract value ratio (MV/CV). It is set at a rate that is equivalent to the portfolio yield adjusted for the difference between
market value and contract value (positive or negative) over the amortization period less the fees that financial institutions charge for the contract.
In the current environment, fees typically range from 0.15% to 0.25% of the investment contract’s value. The amortization period is typically defined
by the duration of the bond portfolio.

The impact of component variables

The crediting rate formula is somewhat complex and, as noted earlier, is primarily affected by these component variables: the market value to contract
value ratio, the yield of the underlying bond portfolio, and the duration of the underlying bond portfolio. While it is not necessary to master
the crediting rate formula, it is important to understand how each of these variables impact the crediting rate.

Market value to contract value ratio

The relationship between the contract value and the market value of the underlying bond portfolio determines whether the crediting rate will be more
or less than the yield of the bond portfolio. Relative to the bond portfolio’s yield, a market value “deficit” (MV<CV) decreases the yield credited
to participants, and a market value “surplus” (MV>CV) increases the yield (see Figure 1). If market value and contract value are equal,
the net crediting rate will be set equal to the yield of the underlying bond portfolio, less the contract fee.

Keeping all other variables constant, an increase in the MV/CV ratio will improve the crediting rate, while a decrease in the ratio will result in
a lower crediting rate. This holds true whether market value is greater than or less than contract value.

Annualized yield to maturity

The yield of the underlying bond portfolio is the portfolio’s expected rate of return at a point in time, assuming bonds are held to maturity and cash
flows are reinvested at the same rate. This is the expected earnings potential of the assets wrapped by the security backed investment contract.

Holding all other variables constant, an increase in the yield of the underlying portfolio will increase the crediting rate. Conversely, a lower yield
will decrease the crediting rate.

Duration

Duration is a measure of interest rate risk, but in the crediting rate formula, the duration variable determines how quickly the difference between
market value and contract value will be amortized. The shorter the duration of the underlying bond portfolio, the more quickly the difference will
be amortized. As previously mentioned, stable value funds typically have durations of approximately three years.

Figure 1 | The Impact of the market value to contract value ratio on the crediting rate

Since duration sets the amortization period, its impact is slightly more complicated than that of the other component variables. When market value
is less than contract value, a loss is being amortized, and a longer duration amortizes the loss over a longer period of time (assuming all other
variables are held constant). An increase in duration therefore results in a higher crediting rate. When market value exceeds contract value and
a gain is being amortized, a longer duration amortizes the gain over a longer period, decreasing the crediting rate. The opposite is true when
duration is shortened, as shown in Figure 2.

Figure 2 | The impact of duration on the crediting rate

Some contract issuers now require a shorter amortization period as a consequence of the financial crisis and deterioration in the market values of
some underlying bond portfolios. Certain contract issuers require crediting rates to be reset based on a percentage of portfolio duration (from
50%-99%) if the MV/CV ratio falls below a certain threshold. By shortening the amortization period for the loss, these contract issuers are
requiring an adjustment to the crediting rate to more quickly narrow the gap between market value and contract value.

A word about management

Examining these “all else equal” scenarios in Figure 1 helps illustrate the impact of changes in each of the crediting rate formulas' component
variables. Yet in reality, stable value funds face a dynamic and constantly shifting market environment. Because each variable can have a dramatic
effect on the crediting rate, it is important for a stable value manager to actively seek to limit the volatility of these factors in the underlying
bond portfolio. Successfully managing the crediting rate inputs is key to assuring that a stable value fund makes good on its name by providing
a consistent rate of return.

The impact of cash flows

Cash flows can also materially impact the crediting rate. Cash deposits to an investment contract whose market value is less than its contract value
improve the MV/CV ratio. Withdrawals that must be made from an investment contract whose MV/CV ratio is below 100% lowers the ratio. The opposite
of each is true when a contract’s market value exceeds its contract value (see Figure 4).

The interest rate environment in which cash flows occur can also affect the crediting rate (see Figure 3). If current reinvestment rates are
lower than the current portfolio yield, substantial cash inflows will negatively impact the yield, and thus the crediting rate. However, if reinvestment
rates are higher than the portfolio yield cash inflows will improve the yield and crediting rate more quickly than if the portfolio relied upon
the reinvestment of its internal cash flows alone.

Figure 3 | Crediting rates

Figure 4 | Impact of cash flows on the crediting rate

A stable value manager can usually control the duration impact of any significant cash flows. Therefore, cash flows typically affect the crediting
rate through the MV/CV ratio and the portfolio yield as described earlier.

From the crediting rate to the participant’s daily yield

In stable value funds that invest primarily in security backed investment contracts, the overall blended yield of a stable value fund­—the daily
yield earned by participants—is primarily determined by the crediting rate mechanism. Participants in a stable value fund earn the average
credited rates of interest on all of the stable value contracts held in the fund. The daily yield is a weighted average based on the investment
value of the individual investments; it also reflects the interest earned on cash held for liquidity purposes as well as the crediting rates of
any other insurance products owned in the fund, such as traditional GICs. Management and administrative fees reduce the yield (see Figure 5).
Like the crediting rate of a security backed investment contract, the yield on a stable value fund generally follows the direction of interest
rates with a lag.

Figure 5 | Daily Yield Calculations

Investment contracts and the use of a crediting rate are critical components for maintaining consistent, competitive yields in a stable value investment
option. These contracts enable an investment manager to invest in a portfolio of short-to-intermediate term fixed income securities, while
insulating plan participants from volatility in the value of their investment. This ability to dampen volatility is a distinct feature of the
stable value asset class, and allows stable value funds to provide plan participants protection against loss of principal and attractive risk-adjusted
returns that have historically outpaced inflation.